As expectations for the Federal Reserve tapering its quantitative easing programs have increased, fixed income markets have become more volatile. For the most part fixed income prices have declined and thus rates have risen. As you can see here, the treasury yield curve is steepening and now showing yields of just under 2% for a 5-year maturity and under 4% for a 30-year maturity. In general, the increasing rates on long-dated maturities are a sign of the expectations of the Fed increasing short-term rates.
So based on where rates are what is the best way to position your portfolio? I have opted for the below approach when considering both preferred securities and debt securities.
1. Preferred stocks
- I have generally looked at variable rate securities that should have the payout rates rise as the short-term rates increase.
- I have tried to find securities where the underlying company should see an improvement in credit quality if rates rise (with the key assumption being rates will increase mainly in combination with an improving economy).
- I have tried to stay in the short to medium-term maturities (so anything up to a 10-year maturity).
- I have typically focused on companies that I think won't have the underlying business significantly impacted with increasing rates (for example, I think business development companies that have a significant portion of their loan balance in variable rate loans could do well, particularly as they secure fixed rate financing).
For the purposes of this article I am focusing on the variable rate preferred stocks (aka adjustable rate). As a quick primer on these types of securities I want to point out that variable rate securities are generally issued by financial institutions (banks, insurance companies, etc) and will usually reference some underlying rate to which the payout is tied to. For example, the ones I have included here are all tied to the 3-month LIBOR rate. As well, most (but not all) will have a floor rate that the payout cannot go below, probably somewhere around 4%. As a point of clarity I am focusing on the floating rate securities, but not fixed-to-floating securities, which will typically have a period of fixed rate payout, and then later on the stocks will transition to a variable payout.
The variable rate securities I am focusing on here all use the 3-month LIBOR rate, which historically has kept pace with the federal funds target rate. So if the Fed starts to raise rates, I expect to see floating rate securities have higher dividends being paid out. Hopefully, this structure will help offset exposure to the short end of the yield curve rising.
In the table below I have highlighted 10 floating rate preferred stocks, from 7 different issuers (different websites use different methodologies for the symbols on preferred stocks… below I have used the symbols in the same way as Yahoo Finance). All of these securities are non-cumulative, redeemable/callable (all happen to be past the redemption date), and yielding somewhere above 4%. All issues listed have a par value of $25 per share, which is also the price at which the issuer would have to redeem. With rates being where they are all of these are paying out their floor level dividend.
GS-PD - Issued by Goldman Sachs (GS) this stock offers a minimum rate of 4% (on par value) and using this minimum rate it creates a current yield of just above 5%. From May 24th 2011 the issuer has the right to redeem these at a liquidation value of $25 per share, plus any accrued and unpaid dividends.
GS-PA - Also issued by Goldman Sachs this stock offers a floor rate of 3.75% on par, which equates to almost 4.7% as a current yield. After April 10, 2010 these are callable at $25 per share, plus any accrued and unpaid dividends.
I believe both of these issues from Goldman Sachs represent the 2nd (and 3rd) most risky securities on my list. That is mainly because Goldman is not a deposit bank (although, in the financial crisis it did convert to a bank holding company giving it access to borrow from the Fed) and in times of severe financial and economic stress it could be vulnerable (see Bear Stearns, Lehman Brothers, etc). Goldman did continue paying the common dividend during the financial crisis (I primarily focused on the period from late 2008 through the end of 2009), but the company did have to raise capital.
BAC-PE - This security is issued by Bank of America (BAC) and similar to the GS-PD above, in that the minimum yield is 4% (on par), but the current yield is slightly below 4.65%. This issue has a liquidation preference of $25 (redeemable since 11/15/2011).
BML-PG - Issued by Merrill Lynch (now part of Bank of America) these offer a slightly lower minimum rate at 3% (on par value) and the current yield is a little above 4%. Similar to the other securities, they are redeemable (since 11/28/2009) with a liquidation preference of $25 (plus accrued and unpaid dividends).
Bank of America does have a strong deposit base, but during the financial crisis the company was really hit hard. Bank of America had to take money from the TARP program, slash its dividend down to $.04 per share (annually) from $.32, and sell assets. Even today it has not raised the dividend and didn't seem as strong as some other major US banks in the US government stress tests. All that said, it did continue to pay preferred dividends and as the preferred shares are better viewed as a debt (than equity) holding it doesn't seem there is significant risk of insolvency (you could also argue Bank of America is too big to fail and the government would bail it out again if needed).
HBA-PF & HBA-PG - Both of these are issued by HSBC (HBC) and are effectively the same security, with the main exception being the floor interest rate. The F series has a floor of 3.5% and the G series 4%, and both series have a current yield above 4.6%. Both are past their call dates and callable at $25 per share.
HSBC is a global bank and has some of the same advantages as Bank of America (being a depositor bank, etc). It has a global reach and also suffered during the financial crisis. During 2009 it slashed its dividend almost in half, but that is still significantly better than Bank of America. HSBC has also raised its dividend since the financial crisis, which shows some level of confidence in its capital position.
MET-PA - This security is issued by MetLife (MET), a large insurance company. That alone makes it a little different as it is the only insurance company on the list. These offer a floor level yield of 4% and currently yield a little above that. They will pay the greater of 4% (on par) or LIBOR plus 1%. They are redeemable at a liquidation preference of $25 per share.
MetLife was able to maintain its common stock dividend during the financial crisis and then this year was actually able to raise the dividend. As the company's website indicates, MetLife has a diverse business, both geographic and from a functional business line perspective. This should help the company during times of stress. Insurance companies tend to have a relatively large portion of their investments in fixed income and as such Metlife (and others) could actually benefit with a rise in long term-rates.
MS-PA - These securities are issued by Morgan Stanley (MS) and offer a 4% par yield if using the floor rate. This equates to a current yield above 5% and the highest on this list. These will pay an additional .70% above LIBOR if that is greater than the 4% on par and they are also currently redeemable by the issuer.
Morgan Stanley is a financial institution similar to Goldman Sachs. This means it isn't a deposit bank, but instead offer services like asset management and investment banking. The company suffered mightily during the financial crisis and was forced to cut its common dividend from more than $1 per share to what is currently $.20 per share (annually). There were some points during the crisis that it wasn't clear if it could survive as a stand-alone business. For all those reasons I would suggest these are the most risky on the list.
USB-PH - This security, issued by US Bancorp (USB), offers a 3.5% floor rate (on par) and will pay the greater of that 3.5% or LIBOR plus .60%. The current yield is just above 4.5% and these are currently redeemable at $25 per share.
US Bank is similar to Bank of America and HSBC in that it has a deposit base as a source of funding. Additionally, consistent with those companies it was negatively impacted by the financial crisis and did significantly cut its dividend. It went from paying $1.70 per share down to $.20 per share (annually), although it has since raised the dividend.
ZB-PA - This security is issued by Zions Bancorp (ZION) and has a floor rate of 4% (on par) and pays the greater of that floor rate or LIBOR plus .52%. It is currently redeemable at $25 per share and has a current yield around 4.7%.
Zions offers a wide range of financial services including retail banking and corporate lending. The company doesn't have the global or national reach as some of the other banks on this list and also isn't nearly as big. It has a focus that covers mainly the west and central part of the US (from Texas to California), but it doesn't have any significant reach into the east coast. It did have similar struggles in the financial crisis slashing the dividend from as much as $.43 per share, per quarter, to $.01 per share, per quarter. It has since repaid TARP money and increased the dividend (to $.04 per share, per quarter). Based on the history noted above and the relatively smaller size, all else equal, I would prefer one of the issues from the larger banks instead.
In general, preferred shares are much more illiquid and don't trade with any meaningful volume. This can translate into strange price movements as well as create a difficult environment to exit a position should you need to sell. Thus, it is of great importance to use limit orders and be patient with such an illiquid security.
Variable rate securities also offer a specific risk and that is that the reference rate (LIBOR in this case) may not match the movement in the US treasury rate. This really depends on which part of the US treasury rate curve we are speaking about, but it is possible that the mid to longer-term rates rise for treasuries (anything from a 5-year maturity or more), and LIBOR doesn't. As the LIBOR rate is what the banks borrow from each other at it should be noted that it can't really go below where the short-term treasury rates are.
One other point to keep in mind here is every investment has an opportunity cost. In this case, the rate you will earn for the securities mentioned here is below what you would get from a fixed-rate preferred share offered by the same issuers. As an example, look at a fixed rate, non-cumulated preferred share offered by Goldman Sachs. GS-PB has a current yield of 6.22% as compared to the variable rate preferred share that is more than 1 percentage point below that. You will see a similar discount when looking across the other issuers.
In order to decide which one (or ones) out of this list may make sense as an investment you really need to decide on your risk preference. You can see the S&P ratings listed in the table and below I included a chart to explain how the different ratings relate to different levels of safety in S&P's opinion. I don't place a lot of weight on the ratings from the ratings agencies because I believe they tend to be more reactive than proactive and you likely won't see downgrades until it is too late.
That said I believe that there are certain groupings from a risk perspective that make sense here. I would consider the Morgan Stanley and Goldman Sachs to be in the riskiest tier, mainly because of their lack of deposits as a source of funding. I would then put Zions Bank in the next grouping because it has a more regional focus (less diverse) and it didn't have a history showing that it managed to make any better decisions than others in the financial crisis. Then in the last tier (the least risky) I would include HSBC, Bank of America, US Bancorp, and MetLife. The first three I would include despite the poor decisions made in the financial crisis and almost because those companies were still able to manage through such a difficult situation and still pay the preferred dividends. MetLife I would include in that grouping because I believe it's managed its risk appropriately and done a good job of staying out of the risky investments.
Once you have decided where you want to be from a risk standpoint then you could start and decide if current yield should be your primary focus. For me, I am primarily focused on the current yield and not nearly as much on the add-on factor. As all of these approach 5% or more I start to get very interested (particularly the safer ones), but each investor should consider their personal situation when making an investment decision.
Additional disclosure: I wasn't able to link the preferred shares, but I am long BAC-PE and GS-PD. I have no other position in the others and no plans to initiate one.